Real option premium in Hong Kong land prices
| DOI | https://doi.org/10.1108/14635780610659946 |
| Pages | 239-258 |
| Date | 01 May 2006 |
| Published date | 01 May 2006 |
| Author | Yat‐Hung Chiang,Chun‐Kei Joinkey So,Chi‐Wai Stanley Yeung |
| Subject Matter | Property management & built environment |
Real option premium in
Hong Kong land prices
Yat-Hung Chiang, Chun-Kei Joinkey So and
Chi-Wai Stanley Yeung
Department of Building and Real Estate, Hong Kong Polytechnic University,
Hong Kong, China
Abstract
Purpose – This paper aims to identify the imbedded option value in price of auctioned land in Hong
Kong, and to propose a more accurate valuation method in predicting land price.
Design/methodology/approach – Based on records of land auctions and property transactions
during two periods of very different market conditions, land prices are estimated using the traditional
hedonic pricing method as well as the option model modified from Quigg. The results are compared to
deduce whether there is any imbedded option value, thus concluding whether the option model
facilitates a more accurate valuation of land prices.
Findings – This study concludes that land auction prices have embedded option value in waiting to
develop land. Option premiums increase with implied volatilities, which go up during market
downturns, suggesting that developers place higher value on the option to develop during recessions.
Research limitations/implications – The accuracy of the analysis may have been compromised
by the limited number of land auctions conducted and the difficulties in inferring the value of
multi-ownership residential buildings from sample transactions of their constituent individual units.
Future research will benefit from a larger sample of transactions.
Practical implications – This paper illustrates that real option models provide the property
industry with a valuation tool that addresses the concern arising from the irreversibility of investment
decisions.
Originality/value – The study finds out the option premiums of vacant land in Hong Kong, lending
empirical support to the application of option-based models for more accurate land valuation
under different market conditions.
Keywords Real estate, Pricing,Hong Kong
Paper type Research paper
Introduction
This study aims to apply real option pricing models to the property market in Hong
Kong. Property valuation based on net present value (NPV) without flexibility taken
into account has been criticized as being static. It undervalues the project or investment
because it does not take into consideration the option of the owner to defer, abandon,
expand, contract or switch project developments or investments. Patel and Sing (2000)
incorporated the effects of rental and construction cost on the decision of real estate
The current issue and full text archive of this journal is available at
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The authors are grateful to FPS Savills International Property Consultants and Jones Lang
LaSalle for their data on building prices and costs, to the anonymous reviewers for their
comments, and to their colleague Mr Man King-Fai for his advice in the early exploratory stage
of the work. This study is funded by The Hong Kong Polytechnic University (Project Code:
A-PD34). All views and the remaining faults in this paper are the responsibilities of the authors.
Real option
premium
239
Received May 2005
Accepted October 2005
Journal of Property Investment &
Finance
Vol. 24 No. 3, 2006
pp. 239-258
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780610659946
development, and discovered that the traditional discounted cash flow model tends to
suggest development to build at the premature time and too low cut-off rental rate.
Developed from financial option methodologies, real option complements
discounted cash flows (DCF) to take into account the alternatives that project
managers usually have in running their projects. Though Lucius (2001) considered that
a systematisation of real estate specific options does not exist, generally speaking, the
alternatives that project managers have could be broadly classified into “Options to
expand”, “Options to alter scale”, “Reduction options”, “Switching options”, “Growth
options” and “Compound options”. Real options are natural extension of the DCF
methodology to capture the full project value derived from their flexibility, var iability
and irreversibility. The total value of a project is the sum of net present value, adjusted
optional value and abandonment value (van Putten and MacMillan, 2004). Real option
pricing is set to be the next central paradigm in real estate finance and investment.
Literature review
There have been numerous studies to apply the seminal Black-Scholes formula (Black
and Scholes, 1973) in pricing financial options. One after another, method ological
studies that dealt with the relaxation of the assumptions in the seminal papers of Black
and Scholes (1973) and Merton (1973) were published. Shortly afterwards, many
studies have applied the option pricing methodology in valuing non-financial or real
assets. Practice-oriented papers that documented industry application of real options
were published. For example, Brown and Achour (1984) used Black-Scholes formul a to
value the option to purchase real assets. McDonald and Siegel (1986) analysed
investment decision to shut down production using real option. Dixit and Pindyck
(1994) and Abel and Eberly (1994) discussed the use of real option in valuing corporate
investment extensively. Amram and Kulatilaka (1999) illustrated the idea with a
portfolio of applications including valuation in start-up business, oil exploration,
developing a drug, buying flexibility, vacant land, and infrastructure investment.
Holland et al. (2000) described a number of studies that concluded the value of waiting.
One common conclusion of these studies is that there exists a negative relationship
between aggregate investment and uncertainty for a cross section of countries and
industries.
In a survey of continuous-time methods in finance, Sundaresan (2000) reviewed key
studies in financial as well as real options. In a special issue of this Journal on real
option, Lucius (2001) provided some systematisation of real option pricing and
suggested classifications based on:
.the different types of options; and
.the various methods to solve partial differential equations.
In this paper (Lucius, 2001), the studies of Titman (1985) and Williams (1991) were
taken as real estate equivalents of the financial call and put options respectively,
whereas the redevelopment options examined by Childs et al. (1996) and Williams
(1997) were regarded as illustrations for call options based on a numeric model and
analytic framework respectively.
Further book chapters focused on literature review were written by Ott (2002) and
Dias (1999). Ott (2002) in particular introduced the empirical studies of Holland et al.
(2000), Ott and Yi (2001), Sivitanidou and Sivitanides (2000), Grenadier (1999) and
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